Déjà vu All Over Again

The Federal Reserve District Banks are quasi-public entities that provide liquidity and other services to their member banks but also act as the primary federal regulator for many of those same banks.  The dual roles as a bankers’ bank and as a regulator create the potential for conflict of interest.  That conflict became apparent as postmortems of the Silicon Valley Bank failure have noted that SVB CEO Gary Becker also sat on the Board of Directors of the San Francisco Fed.  The dual roles of the Federal Reserve Banks have received relatively little scrutiny until recently, but the situation is not historically unique.  A similar issue arose with the Federal Home Loan Bank System in the 1980s.

The Federal Home Loan Bank System was established during the 1930s to promote home ownership.  Member banks purchase FHLB stock and could access to FHLB advances to fund home mortgages.  Until 1989, the Federal Home Loan Bank Board (FHLBB), a government agency, oversaw this process.  However, FHLB’s had significant autonomy with boards consisting of representatives from member banks as well as public interest directors.

Early in my career, the oversight of S&Ls had two distinct components (later melded):  examinations and supervision.  Examiners would go onsite at an S&L, typically once every 12 to 18 months.  The Report of Exam would describe and rate the bank’s condition but did not initiate corrective action.  That rested with supervisory agents and analysts, who prepared a transmittal, called a Supervisory Letter, summarizing the exam’s findings.  Supervisory Letters could suggest improvements or initiate more formal enforcement actions.  Supervisory analysts also conducted financial monitoring between exams.

From the outset, supervision was the responsibility of the District Banks, who were designated as agents of the Bank Board.  The District Bank President was normally also the Principal Supervisory Agent.  The head of supervision would be an officer of the bank and reported to the Bank President.  Until the 1980s, the supervision function was lightly staffed.  Examiners, on the other hand, were government employees, who reported to the FHBB in Washington.

That relationship changed in 1985, when the Bank Board transferred the examination function to the District Banks.  The FHLBB hoped that having both examination and supervision under the same umbrella would improve coordination between the two functions.  Better coordination could reduce the lag between discovery of problems by examinations and taking corrective action by supervision.  Moving the examinations under the District Banks also removed federal government constraints on pay and staffing, allowing the functions to staff up as the industry’s problems got worse. In an audacious move, the Bank Board initiated the change without supporting legislation.

Moving the regulatory functions to the Federal Home Loan Banks created problems of their own.  The quality of examinations and supervision varied considerably between District Banks.  The Bank Board tried to mitigate some of these problems with policy guidance and “peer reviews,” where teams of examiners and supervisors from one or more FHLBs would rate the regulatory function of another FHLB.  A Peer Review of the Dallas Home Loan Bank identified numerous weaknesses in Dallas’ examination and supervision functions and found instances where directors at the Dallas Bank appeared to receive kid glove treatment by regulators.

Following a wave of S&L failures and depletion of the S&L insurance fund (FSLIC), Congress enacted the Financial Institutions Reform, Recovery and Enforcement Act (FIREA) in 1989.  FIRREA abolished the FHLBB and replaced it with the Office of Thrift Supervision, under the Treasury Department.  The FHLBs remained as bankers’ banks but no longer had a role in bank supervision.  OTS and the other banking regulators retained flexibility in budgeting and compensation.  FIRREA required pay comparability across agencies, but did not require adherence to the General Schedule.  The legislation included numerous other reforms.  FIRREA passed with broad support that is hard to imagine in today’s hyper-partisan era.  Before we get too nostalgic, also bear in mind that a broad bipartisan coalition spent the previous ten years undermining the regulators at every turn.

The District Bank peer reviews were confidential and not widely shared even among the regulatory community.  That changed a bit in 1990 when then-Congressman Chuck Schumer held hearings on the Dallas peer review.  I participated in the Dallas peer review, so the big boss invited me to watch the proceedings from a TV set in his office.  The hearings make for fascinating viewing.  The dual role of the Federal Home Loan Banks appalled one of my colleagues, who described it as “incestuous.”  When I pointed out that the Federal Reserve operates under a similar system, he mumbled something about the Fed’s situation as being different.

How different isn’t entirely clear.  There may be additional safeguards in place.  However, I recall attending a regulatory symposium hosted by the Federal Reserve Bank of New York in 2007.  The New York Fed’s then-President, Tim Geithner introduced one of the featured speakers, Jamie Dimon. Geithner described Dimon as a “rock star,” and joked that since Dimon served on the New York Fed’s board, he was Geithner’s “boss.”  The remark was meant to be in jest, but the fawning introduction was not a good look for a regulator.

I doubt whether the Fed’s upcoming internal review of the SVB failure will recommend fundamental changes to the role the district FRBs play in bank supervision.  Such a change might require new legislation (good luck with that), but that’s not obvious.  One potential concern is that the reorganization of the district banks might prompt a staff exodus at an inconvenient time.  However, I’m not aware of evidence that District Bank earn much more than those for Federal Reserve Board employees or for other regulators.

District Bank compensation is more easily kept under wraps, which might appeal to the Fed’s penchant for secrecy.  In addition, examiners earn more than most government employees, making them an inviting target.  For example, Paul Kupiec of the American Enterprise Institute suggested that bank regulators are overpaid by comparing the average salary at bank regulatory agencies to the average salary at banks.  This analysis glosses over the reality that more than 60% of agency employees are bank examiners, who typically face off with bank executives and not tellers or call center employees.  Kupiec previously worked with the FDIC and should know better.  It’s easy to see where the district Federal Reserve Banks want to spare themselves and their staff of such nonsense.  That’s not a compelling rationale, however, to avoid otherwise needed reform.

The Fed might just take the view that if it ain’t broke, don’t fix it.  SVB certainly looks like a supervisory failure at some level, but one case does not make for a systemic problem.  However, federal interventions following SVB’s collapse were so massive that it’s hard to tell whether these interventions fixed similar problems at other banks or just papered them over.